Risk arbitrage returns

July 2008 -0.39% to 0.8% Year-to-date -0.22% to 2.98%

With the last few deals from the buyout-binge days exiting the risk arbitrage merger pool -- along with losses associated with those deals -- arbs are looking toward a brighter horizon.

They have modest reasons to be hopeful: A sampling of studies by hedge fund trackers show that risk arbitrage, while producing modest returns in recent months, is nevertheless near the top of hedge fund investment strategies by performance.

The Hennessee Group LLC's merger arbitrage index is up 2.36% year to date; Credit Suisse/Tremont posts that arbs are up 2.98% so far this year; Hedge Fund Research Inc. reports they are down a modest 0.22%; and Greenwich Alternative Investments posts a year-to-date performance of -0.03%.

Risk arbitrage, or merger arbitrage, is at its core the practice of investing in announced M&A deals to capture the spread between the price of a public equity and its value in an agreed-upon merger contract. As such, it is an insurance business wherein arbs price a risk premium for a deal surviving its potential pitfalls and making it to a close, including the time involved in the process. That premium is the deal spread.

Merger arb is supposed to be a market-neutral strategy, but in practice it is not completely free of broader equity market exposure, especially when the merger pool is weighted toward cash deals, as it has been in recent years.

Hennessee's 2.36% YTD return may not seem stellar, but by comparison, only three other hedge fund strategies of the 23 it tracks are currently in the black, and only two bested the merger arbs, according to its data. Hennessee has its short-biased index coming in at 12.69% YTD, while macro was up 4.04%.

Credit Suisse/Tremont similarly shows risk arbitrage beaten out this year only by dedicated short selling (9.02%), global macro (6.34%) and managed futures (4.79%).

Greenwich, which found the lowest posted YTD return for arbs, reports the strategy was beaten by equity market neutral (4%), short selling (9.8%), futures (9.3%) and market timing (0.4%).

For July, arbs reporting to Hennessee had an average return of 0.7%, edged out only slightly by short sellers returning 0.8% but besting the Hennessee hedge fund group July performance of -1.95%. CS/Tremont reports its arb funds' July return at -0.39%, HFRI posts a 0.37% July gain, and Greenwich reports a gain of 0.6%, just behind the top category of statistical arbitrage at 0.9%.

So it looks as if risk arbitrage is holding its own, and the outlook for the coming months seems positive. Dealflow, while still off from a year ago, has picked up from the credit crunch lows. The J.P. Morgan risk arbitrage department -- the former Bear, Stearns & Co. operation -- currently includes about 60 deals in its North American pool, for an aggregate target value of $432 billion, which is up from about 50 deals worth roughly $250 billion in early June.

One arbitrage portfolio manager says that risk arbitrage essentially treaded water in 2007 while other markets got creamed. He notes that current spreads, while broad in range, are attractive, with annualized returns commonly in the double digits.

That's a nice comparison with the spring of 2007, when many LBO deals were trading at tight spreads, only to unravel. And he predicts that over the next 12 months, the success rate for deal closings should climb higher.